PRINCIPLES OF

OPTIONS
 DEFINITION

Option
Buy and s
ell specifi
specified ed asset
price and at
time.

Exercise
Price-Agree Buyer,
Taker,
today, choos Holde
e wit h r has r
xecute
Exe out ob ight to
later. buy/se ligation to
ll
 CONCEPT OF OPTION

BUYER
• Known as holder/taker
• Pay premium to seller
• Right to buy/sell

SELLER
• Known as writer/grantor
• Receive premium from buyer
• Obligation to buy/sell
 TYPES OF OPTION

PUT OPTION CALL OPTION

BUYER Right to sell asset at Right to buy asset at

or before maturity or before maturity
period.(Long Put) period. (Long Call)

SELLER Obligation to buy Obligation to sell

asset at specified asset at specified
price. (Short Put) price. (Short Call)
 OPTION PRICE

• Premium= Intrinsic Value+ Time Value

• Call Option= MP-SP (never be (-))
• Put Option= SP-MP (never be (-) )

MP= Market Price

SP= Strike Price
KEY ELEMENTS OF OPTIONS

1. UNDERLAYING ASSET
• Type of asset that underlies option contract
• For KLCI Options,it is a derivative instruments or Contract.
• For futures trading,BMDB is the option market while BMSB is
the underlying or cash market.

2. EXERCISE PRICE/STRIKE PRICE

• Price that the buyer(holder) has the right to sell or buy the
Underlying that is displayed at the cash market.
• “strike” used to indicate the holder has to exercise his right
whenever his option strike the price.
3. CURRENT MARKET PRICE
• This is the price of the underlying asset that is displayed in
cash market.
• Like futures contract,the price of option is
derived from the actual price of its underlying.

4. PREMIUM
• Price of option and is determined by the bid and ask price in
the market.
• Investors who buy an option will pay premium while a seller
will receive it.
5. EXPIRATION DATE/MATURITY DATE
• Last day which the option will exercise.
• If the holder does not exersice until maturity date,the
option will become worthless.
• KLCI option : European types
• Stock option : American types
 7.4 OPTION PRICING AND MONEYNESS
OPTION PRICES
• The amount of money that the buyer of an option pays to the
seller for the right, but not the obligation, to exercise the
option. 
• called as option premium.
• Option prices/premium = intrinsic value + time value.
• Intrinsic value defined as the value of the option when it is in-
the-money.
• Call option
intrinsic value = market price – strike price
• Put option
intrinsic value = strike price – market price
MONEYNESS

• A description of a derivative relating its strike price to the

price of its underlying asset. Moneyness describes the
intrinsic value of an option in its current state.
• Moneyness tells option holders whether exercising will lead to
a profit.
• There are many forms of moneyness
– In-the-money
– Out-the-money
– At the money
• Moneyness looks at the value of an option if you were to
exercise it right away.
• A loss would signify the option is out of the money, while a
gain would mean it's in the money. At the money means that
you will break even upon exercising the option.
AT-THE-MONEY

• The one that would lead to zero cash flows to the holder if it
were exercised immediately.
• A situation where an option's strike price is identical to the
price of the underlying security.
• Both call and put options will be simultaneously "at the
money.“
 IN-THE-MONEY

• The one that would lead to the positive cash flows to the
holder if it were exercised immediately.
• That your stock option is worth money and you can turn
around and sell or exercise it.
• For a call option, when the option's strike price is below the
market price of the underlying asset. For a put option, when
the strike price is above the market price of the underlying
asset.
• Being in the money does not mean you will profit, it just
means the option is worth exercising. This is because the
option costs money to buy.
 OUT-THE-MONEY

• The one that would lead to negative cash flows to the holder
if it were exercised immediately.
• An out of the money option has no intrinsic value, but only
possesses extrinsic or time value. As a result, the value of an
out of the money option erodes quickly with time as it gets
closer to expiry. If it still out of the money at expiry, the option
will expire worthless.
• A call option with a strike price that is higher than the market
price of the underlying asset, or a put option with a strike
price that is lower than the market price of the underlying
asset.
 Long Call
Profit

PROFIT = UNLIMITED
BE
LOSS = LIMITED
(PREMIUM PAID)

Loss

• Expected the market to be very bullish

• BE = XPrice + Premium
• Pay off = CMP – XPrice - Premium
 Short Call

PROFIT = LIMITED
Profit
(PREMIUM RECEIVED)
BE

LOSS = UNLIMITED

Loss

• Expected the market to be bearish

• BE = XPrice + Premium
• Pay off = XPrice – CMP + Premium
 Long Put
Profit

PROFIT = UNLIMITED
BE

LOSS = LIMITED
(PREMIUM PAID)
Loss

• Expected the market to be very bearish

• BE = XPrice – Premium
• Pay off = XPrice – CMP - Premium
 Short Put

BE
Loss PROFIT = LIMITED
(PREMIUM
RECEIVED)

LOSS = UNLIMITED
Profit

• Expected the price to be bullish

• BE = XPrice – Premium
• Pay off = CMP – XPrice + Premium
 Long Straddle

Profit = Unlimited
Loss = Limited
BE(1) BE(2)

Highly volatile; Moving in either direction

Long Call + Long Put
Loss
XLC=XLP
BE (1) = XLP – Total Premium
BE (2) = XLC + Total Premium
 Short Straddle

Profit = Limited
Loss = Unlimited
BE(1) BE(2)

No Volatility; Quite for some time Profit

Short Call + Short Put
XLC=XLP
BE (1) = XSP – Total Premium
BE (2) = XSC + Total Premium
 Long Strangle

Profit = Unlimited
Loss = Limited

High Volatility ; Wide Range of Trading

Long Call + Long Put
XLC > XLP
BE (1) = XLP – Total Premium A = BE(1) B = XLP
BE (2) = XLC + Total Premium
C = XLC D = BE(2)
 Short Strangle

Profit = Limited
Loss = Unlimited

Low Volatility ; Narrow Range of Trading

Short Call + Short Put
XSC > XSP
BE (1) = XLP – Total Premium A = BE(1) B = XLP
BE (2) = XLC + Total Premium
C = XLC D = BE(2)
 Bull Call
(Bullish With Limited Upside)

XLC < XSC

PLC > PSC

Max Profit= (XSC-XLC) – (PMLC-PMSC)

Max Loss= PMLC - PMSC
BEP = Lower X + Net Premium
 Bull Put
(Bullish With Limited Upside)

XLP < XSP

PLP < PSP

Max Profit= PMSP - PMLP

Max Loss= (XSP-XLP) – (PMSP-PMLP)
BEP = Higher X – Net Premium
 Bear Call
(Bearish with Limited Downside)

XLC > XSC

PLC < PSC

Max Profit= PMSC - PMLC

Max Loss= (XLC-XSC) – (PMSC-PMLC)
BEP = Lower X + Net Premium
 Bear Put
(Bearish with Limited Downside)

XLP > XSP

PLP > PSP

Max Profit= (XLP-XSP) – (PMLP-PMSP)

Max Loss= PMLP - PMSP
BEP = Higher X - Net Premium
THE END